Of all the forms of securities, common stocks (and derivatives of common stocks) are the most romantic. Although the bond markets are quite important to both issuing corporations and many investors (pension fund money, life insurance reserves, bank portfolio funds, and so on in the aggregate are more heavily invested in bonds than equities), it is the stock market that engenders the interest of most investors. This is undoubtedly true because the rewards (and penalties) of stock market investment well exceed those obtainable in the bond market. Furthermore, equity analysis is more complicated than bond appraisal, and greater skill is required in selecting common stocks than fixed income securities. This is not to say that bond analysis is simple or even uninteresting. Indeed, some of the more sophisticated minds in the investments business are engaged in the bond market. Nevertheless, few people spend their lunch hours talking about the bond market, and the future performance of a bond rarely comes up in bridge table or golf course discussions. It is common stocks that entice most investors, and some investors have been known to feel a greater empathy for their stocks than their spouses. Thus, common stocks (and derivatives of common stocks) will be our focal point in the discussion in this chapter.

There is a school of thought that maintains that only insiders and those privileged to have information not known to the rest of us can make large profits in the stock market. These people subscribe to a theory of stock prices called the efficient market hypothesis (EMH). EMH advocates argue that the current price of a stock contains all available information possessed by investors and only new information can change equity returns. Because new information becomes available randomly, there should be no reason to expect any systematic movements in stock returns. Advocates of the EMH feel that the stock market is perfectly efficient and the cost of research and investigation would not be justified by any "bargains" (that is, undervalued stocks) found.

The EMH has been tested by a number of scholars. These researchers have considered various hypotheses about the behavior of the stock market, from notions that past stock prices can be used to forecast future prices (the belief held by stock market chartists or "technicians") to reasoned opinions that stocks exist that are undervalued by the market and that these stocks can be uncovered by a thorough investigation of such fundamental variables as reported earnings, sales, price-to-earnings (P/E) multiples, and other pieces of economic or accounting data. The latter view of the market has long been held by most investors, and the whole profession of security analysis depends upon it. From the early days of the first edition of Graham and Dodd (1934) down to the present, analysts have been taught that there are overpriced stocks and underpriced stocks and it is the job of the analyst to determine which are which. The EMH advocates have found, however, that the presence of so many individuals trying to find bargains (and overpriced stocks to sell short) makes it impossible for any one of them to outperform the general market consistently. Thus, as the economy grows and earnings increase, it is possible to make money in the stock market, but it is impossible to expect more than "average" returns. This is true, they say, because there are many buyers and many sellers in the market who have a great deal of similar information about stocks. If any one stock were "worth" more than the price for which it was currently selling, sharp analysts would recommend buying until its price rose to the point at which it was no longer a bargain. Similarly, if a stock were selling for more than its intrinsic value, analysts would recommend selling. The price of the security would fall until it was no longer overpriced.

The EMH has gained great currency in many quarters, particularly among academic economists, beginning in the early 1970s (see Fama, 1970). Nevertheless, it has not convinced too many practitioners, and many financial economists today no longer accept the EMH unequivocally (see Fama, 1996, and especially Haugen, 1999). This may be for two reasons. In the first place, if the EMH were believed, it would be hard for professionals to justify the salaries that they are paid to find better-than-average performers. Second, many analysts have suggested that their very presence is required for the EMH to work. If they could not find undervalued stocks, they would not come to their desks each day; and if they did not appear, there would no longer be that vast army of competitors to make the stock market efficient and competitive! Moreover, many analysts point out that there are substantial differences of opinion over the same information. Thus, although every investor may have available similar information, some see favorable signs where others see unfavorable ones. Furthermore, various analysts can do different things with the same data. Some may be able to forecast future earnings, for example, far more accurately than others simply because they employ a better analytical and more systematic approach. It is these differences of opinion and analytical abilities that make a horse race, and most practitioners (and an increasing number of financial economists) believe that this is what the market is all about.

Long before the EMH began to gain advocates, many economists (and almost all practitioners) believed that the stock market was neither competitive nor efficient (see Williams and Findlay, 1974). These individuals viewed the market historically as an expression of the whim and fancy of the select few, a large gambling casino for the rich, so to speak. It has been observed that securities speculation in the past has been far from scientific and that emotion rather than reason has often guided the path of stock prices. Inefficiency proponents believed that people are governed principally by their emotions and that bull and bear markets are merely reflections of the optimism or pessimism of the day. They argued that economics plays a slight role in the market and that investor psychology is more important. This view traces back over 130 years. Charles Mackay (1869), in a famous book published in 1869, entitled Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, argued:

Mackay's fascinating story details some of the most unbelievable financial events in history:

In fact, as Mackay was writing, Jay Gould and Jim Fisk were busily manipulating the value of the shares of the Erie Railroad in the United States [see Adams and Adams (1956)]. It was common practice for directors in many companies to issue information causing the price of their firm's stock to rise. They then sold their shares at inflated prices to the unsuspecting public. Some months later, they would release discouraging information about the company's prospects, in the meanwhile selling short the shares of their company. When the new information drove the price of the shares down, the directors would cover their short positions, again reaping nice profits at the expense of the unaware.

These practices continued on into the 1920s, an era when everybody believed that the life style of a J. P. Morgan or a Harvey Firestone could be within his reach. As Frederick Lewis Allen has pointed out in his wonderfully nostalgic yet penetrating Only Yesterday, it was a time when "the abounding confidence engendered by Coolidge Prosperity ... persuaded the $40,000 a year salesman that in some magical way he too might tomorrow be able to buy a fine house and all the good things of earth"(Allen, 1931, p. 11). A speculative binge started in 1924 with the Florida land boom (where "investors" paid large sums of money for plots that turned out in many cases to be undeveloped swampland) and continued on throughout most of the rest of the decade. As historian David Kennedy has pointed out, "Theory has it that the bond and equity markets reflect and even anticipate the underlying realities of making and marketing goods and services, but by 1928 the American stock markets had slipped the bonds of surly reality. They catapulted into a phantasmagorical realm where the laws of rational economic behavior went unpromulgated and prices had no discernible relation to values. While business activity steadily subsided, stock prices levitated giddily" (Kennedy, 1999, p. 35). All this came to an end with the stock market crash (and Great Depression that followed) in October, 1929.

From the Gilded Age to the 1920s, stock values were based on dividends and book value (that is, net asset value per share). In other words, stocks were valued much like bonds, based on collateral and yield. Since it was hard to "fake" a dividend, manipulators often resorted to "watering the balance sheet" (writing up asset values to unreasonable levels so as to raise the book value). This discussion seems quaint today with the Securities and Exchange Commission (SEC) requiring an accounting change (eliminating pooling on acquisitions), which will result in "watering" balance sheets in much the same way as in days of yore.

Earnings and even earnings growth as a basis for value were touted during the 1920s, especially to justify the ever higher prices. The book often cited for providing intellectual justification for the stock market excesses of the 1920s was Edgar Lawrence Smith's, Common Stocks as Long Term Investments (Smith, 1924). This is really an unfair assessment. What Smith did show, going back a century over periods of severe inflation and deflation, was that a diversified portfolio of stocks held over long periods might expect to earn a current yield of the short (e.g., commercial paper) rate and appreciate (from the retention of earnings) at about 2.5%, which can probably be interpreted as a "real" (inflation adjusted) return. At current values, this would translate to a shareholder rational required return of about 10% for the average stock. Not only is that estimate quite reasonable but it also is consistent with studies of long-run equity returns since the 1920s by the firm of Ibbotson Associates. Furthermore, it contrasts with the arguments of the Dow Jones 40,000 crowd who contended, at the beginning of the year 2000 at least, that the average stock should currently be selling at 100 times earnings (see Glassman and Hassett, 1999). The market correction that began in March 2000 has pretty much laid this notion to rest.

With the 1930s came the first edition of Graham and Dodd's classic Security Analysis. Graham and Dodd (1934) devoted much of their attention to adjustments to make financial statements more conservative. They would allow conservative P/E multiples on demonstrated, historical earning power, with considerable attention again paid to book value and dividends. Finally, a much neglected book, J. B. Williams's The Theory of Investment Value, also appeared (Williams, 1938). In it he developed most of the valuation formulations of financial mathematics. Along the way, he demonstrated that share price could be expressed as the discounted present value of the future dividend stream. Such currently trendy notions as free cash flow analysis and economic value added flow from his work.

Thus, in normal markets, the valuation approaches basically argue that investors should pay for what they can see (net assets, dividends) or reasonably expect to continue (demonstrated earning power). As markets boom, more and more optimistic future scenarios need to be factored into rational valuation models to obtain existing prices. Beyond some point the assumptions become so extreme that explanations other than rational valuation suggest themselves.

Although the EMH was yet decades away, economists in the 1920s and 1930s did advance the notion that markets should conform to some rationality which, with its great rise and collapse, the stock market seemed not to obey. John Maynard Keynes was one of the more perceptive observers of this phenomenon; and in 1936, he wrote The General Theory of Employment, Interest, and Money (Keynes, 1936). He believed that much of man's social activities (including the stock market) were better explained by disciplines other than economics. Keynes felt that "animal spirits" exercised greater influence on many economic decisions than the "invisible hand." His reasoning was based partly on a very acute understanding of human nature. It also depended on Keynes' lack of faith in the credibility of many of the inputs that go into economic decision making. He argued, "... our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield" (Keynes, 1936, p. 152). He argued further that "... the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities."

To Keynes, the market was more a battle of wits like a game of Snap, Old Maid, or musical chairs than a serious means of resource allocation. One of the most often quoted metaphors in the General Theory tells us:

In the stock exchange, pretty girls are replaced by equities that one speculator believes will appeal to other speculators. Thus,

During this period, economists would discuss efficiency in two ways—neither of which is related to the efficiency in the EMH. Allocational efficiency related to transmitting saving into investment and also investment funds to their highest and best use. Such issues arose in the debate over central planning versus market economies. Transactional efficiency related to the costs of trading (e.g., commissions and taxes, bid-ask spread, round-trip costs, etc.). Keynes favored high trading costs, both to keep the poor out of the casino and to force a longer-term commitment to investments. He was also not optimistic about the ability of the market to allocate capital well ("when the investment activity of a nation becomes the byproduct of a casino, the job is likely to be ill done.")

Keynes's view was generally adopted by economists at least until the 1950s. A leading post-Keynesian, John Kenneth Galbraith, argued along Keynesian lines in his book The Great Crash (Galbraith, 1955) that stock market instability (inefficiency) had been important in economic cycles in the United States since the War between the States and that the 1929 collapse was a major factor leading to the Great Depression of the 1930s. Attitudes about the nature of the stock market began to change in the 1960s, and many financial economists began to interpret stock price movements as a "random walk."

In sum, the 1929 crash and Great Depression were still very recent memories as the United States emerged from World War II. The Securities Acts (see the following discussion) passed during the 1930s were predicated upon the view, rightly or wrongly, that fraud pervaded the markets. Certain financial institutions were either prohibited or generally severely restricted in their ability to hold common shares. A "prudent man's" portfolio would still be mostly (if not all) in bonds. The stock market was, at worst, a disreputable place and, at best, a place where one not only cut the cards but also distrusted the dealer.

Viewed in this context, the EMH becomes one of the most remarkable examples of image rehabilitation in history. From a very humble start, within a decade or two it had converted numerous academics. By the end of its third decade, it had converted a plurality of the U.S. Supreme Court! Whether these people (especially the latter) know it or not, they have adopted the position that an investor, having undertaken no analysis, can place a market buy order for any stock at any time and expect to pay a price which equals the true value of the shares. In other words, they now have so much trust in the dealer that they do not even bother to cut the cards!

A fundamental postulation of the efficient market hypothesis is that investors (except insiders) have similar information with which to work. Indeed, the entire foundation of the EMH is based on the presumption that all data have been digested by the market and that the current price of a security reflects all available information. Opponents of the EMH believe that information is not perfectly disseminated among investors and that investors may tend to interpret information differently. Because the ability to make above-average returns in the market depends upon differences in the flow and understanding of information, it is very important that the purchaser of securities appreciate all the possible sources of financial data.

A large quantity of information is generated by agencies and services that put together reports for the investing public (institutional and personal). These reports vary from general economic prognostications to very concrete analyses of industry and corporate prospects. Moody's, Standard & Poor's, and FitchRatings supply numerous bulletins and reports on a daily, weekly, and monthly basis. The Value Line Investment Survey publishes reports on hundreds of companies and ranks stocks in terms of quality, potential short-term and long-term price performance, and yield. Brokerage and investment banking houses also publish numerous reports that analyze and evaluate individual companies and securities. The bigger firms maintain substantial staffs of analysts, and it is not unusual for major entities to have analysts who cover the securities in only one industry.

In addition to the services listed above, there are a number of private investment letters that are distributed to a clientele of paid subscribers. These letters cost varying amounts, from a few dollars per year to thousands of dollars per year, depending on the nature of the information provided and the previous track record of the publishers of the letter. Some investment letters have been prepared for years and are widely respected.

An unfortunate feature of the aforementioned reports, however, is that the information that they contain is available to a large audience. Thus, if one of the leading brokerage houses recommends a particular stock, that knowledge is immediately transmitted to all participants and incorporated into stock prices. If only these data existed, there would be a good reason to accept the EMH on a priori grounds. There are other pieces of information, however, that may not be easily transmitted or understood. Important data are not always available to the general public, and even when widely disseminated some information is not easily interpreted. Data in the latter category often appear in the financial press and require specialized knowledge for proper understanding. Although many of the articles that are found in such publications as the Wall Street Journal, Barron's, Forbes, Fortune, and BusinessWeek are very specific and provide obvious input in the appraisal of a firm, frequently it is not easy to make sense of an isolated fact that may be reported about a particular company. For example, suppose a firm reports its third quarter earnings and the statement is immediately carried by the Wall Street Journal. Suppose further that reported earnings are up significantly from the previous quarter and from the same period (quarter) in the previous year. What does this mean? The average reader might assume that the report is bullish and that the firm has done well. However, he looks at the price of the firm's stock and finds that it went down with the publication of the information. How can this be explained? One possibility is that professional analysts who had been scrutinizing the company very carefully for years had expected the firm to do even better than the reported figures and were disappointed by the result. Another possibility is that the market had discounted the good news (that is, the improvement was expected and the price of the stock had been previously bid up accordingly). When the news was not quite as good as expected, the market realized that it had overanticipated the result, and the price thus had to fall.

Information of this sort can often bewilder the "small" investor, and even the seasoned analyst is sometimes surprised by the way the market reacts to certain new inputs. Nevertheless, it is situations such as these that make possible above-average stock market performance. The investor who went against the crowd with the belief that the firm was not going to do as well as others expected and sold his shares (or established a "short" position) would have profited. Here, of course, superior forecasting or a better understanding of the situation would have enabled the shrewd investor to realize better-than-average returns. Hence, it is clear that the appropriate evaluation of financial information is the key to long-run investment success, and the trained analyst will have a decided advantage. Because the published investigations of others will very likely be generally available, and hence already included in the current price of a security, it should be obvious that the portfolio manager or private investor who really desires above-normal profits will have to make independent evaluations. The inputs that go into independent appraisals may include publicly available information, such as a corporation's annual report and Form 10K, but these data will be uniquely interpreted. Moreover, the professional analyst may have access to certain inputs that are not generally known to the public. Competent securities analysts spend many hours each week interviewing corporate officers and employees of the firms that they follow. The capable analyst learns how to take clues from what managers say and use these clues to good advantage. This is not quite as good as inside information, but the really top analysts can sometimes deduce facts from evidence garnered that equals that possessed by management. These people are rare, however, and they are very highly paid. Moreover, this source is becoming increasingly limited by the SEC Rule FD, which requires companies to specify certain officers (employees) who can communicate with the investing public and requires immediate public dissemination in the event of inadvertent disclosure of material information.

Computers are used to perform tasks in a matter of seconds that previously required thousands of man hours, and a whole new industry (financial information technology) has come into existence that has offered its own stock market high fliers in recent years. Significant amounts of data are now "online," including "First Call" earnings estimates of analysts, "ProVestor Plus" company reports, Standard & Poor's Stock Reports, Vickers "Insider Trading Chronology," and virtually all press releases made by every publicly-held company. SEC filings are immediately available from EDGAR (electronic data gathering and research) On Line (edgaronline.com), which also provides a "People Search" with information on directors and officers, including salary and stock option data. Other similar information is provided by Yahoo! (finance.yahoo.com). Other useful web sites include the following: smartmoney.com; premierinvestor.com; moneycentral.msn.com; fool.com; CBS.marketwatch.com; bloomberg.com; Kiplinger.com; bigcharts.com; and Morn-ingstar.com. Also, most publicly held companies maintain web sites that post all major information about the company. Of course, one should not overlook the various "chat" room sources (which are mostly "gripe" sessions from disgruntled employees—some stockholders as well), the information content of which have only recently become the subject of academic research.

There is another prerequisite even more important than widely available information to the efficient market hypothesis: the existence of large, well-behaved securities markets. From economics, it will be recalled that a perfectly competitive market is one in which: (1) there are many buyers and sellers, no one of which can influence price; (2) there exists perfect information that is costless and equally available to all participants in the market; (3) there is a homogeneous commodity traded in the market; (4) there is free entry of sellers and buyers into the market (no barriers to entry); and (5) there is an absence of taxes and other transaction costs (e.g., brokerage commissions). The price observed in such a perfect market would be not only efficient but also in equilibrium. Clearly, however, no market meets this sufficient condition for the EMH. Advocates of the EMH would contend that the price could behave "as though" it were efficient if none of the above conditions were even approximated. (For a further discussion, see Chapter 5 in Thompson, Williams, and Findlay [2003].)

The discussion earlier on the role of financial information in the market efficiency question, as well as the discussion later on the role of securities market regulation in the market efficiency question, deals with the descriptive validity of the information availability assumption. This section and the next deal with the question of which "price" is assumed to be efficient. For example, if a stock is quoted $5 bid, $10 asked, what is the price which supposedly unbiasedly estimates the fully informed value? Likewise, if uninformed trading pushes the price up or down from the last trade, which is the right price? Finally, later in this chapter our attention turns to trying to identify the market return that one cannot expect to beat.

For a market to be competitive, it usually must be sufficiently large so that any buyer (or seller) can purchase (sell) whatever quantity he or she wishes at the "going" price (that is, the price set through the negotiations of all buyers and sellers together). The securities markets generally satisfy the size requirement in that literally billions of dollars worth of stocks and bonds are traded daily just in the United States. This does not mean that there is a good market for every single stock or bond in the hands of the public, however. If there is sufficient trading depth in a particular security, it will be possible to trade at a price very near the most recent past transaction price. As many investors can testify, however, there are numerous stocks (and many more bonds) that trade in very thin markets. That is, the number of participants in the market is so small that one may have to bid well above the last price to buy or ask well under that price to sell. Such a market is clearly not even nearly perfect.

To a large extent, whether or not a particular stock or bond is traded in a broad market depends on the "floating supply" of the issue outstanding. A stock with only a million shares in the hands of the public that "turns over" only 10% of the supply annually (that is, 100,000 shares annually, or less than 500 shares on average each business day) will probably not trade often enough or in sufficient quantity to have market depth. Such a security may show rather substantial price volatility from one transaction to the next since the time span between transactions may be several hours or even days. Thus, no one buyer could accumulate more than a few shares at any one time without driving the price higher. Similarly, no seller could liquidate much of a position without pushing the price down.

One way to be sure that a stock does have a reasonably large floating supply and regular transaction patterns is to make certain that it is traded in an organized market, and organized securities markets have existed for centuries. Records show that securities were trading as early as 1602 in Antwerp and that an organized exchange existed in Amsterdam by 1611. Today, most of the leading capitalist countries have at least one major exchange, and the United States boasts several. In North America, the New York Stock Exchange (NYSE) is still the most important market, but the Nasdaq (a computer-based automatic quotation service) list competes with many newer, "high-tech" stocks. Securities listed on the American Stock Exchange and the regional exchanges do not generally have the market depth (or the earnings and assets) of stocks listed on the NYSE. Options on common stocks are traded on the Chicago Board Options Exchange (CBOE) and on the American, Pacific, and Philadelphia stock exchanges.

Many securities are traded on more than one exchange. An advantage of dual listing is that extra trading hours may be secured for a firm's stock. Thus, a company's shares listed on the NYSE and the London and Tokyo Stock Exchanges could be traded almost around the clock. In fact, there is almost continuous trading in most major stocks held worldwide even when an organized exchange is not open. A disadvantage of this extended trading may be increased volatility. (For a further discussion, see Chapter 5 in Thompson, Williams, and Findlay [2003].)

On an exchange, there is a record of each transaction, and an investor can observe the last price at which the security was traded. The investor may call his or her broker (or check an online trading account) and find out at what price a particular stock opened (its first price for the day), find the high and low for the day, and obtain a current quotation with market size. A bid price is the amount that is offered for the purchase of a security and the ask price is the amount demanded by a seller. There will customarily be a "spread" between the bid and ask prices that serves to compensate those who make a market in the security (a specialist on most exchanges and various dealers on the Nasdaq).

The primary market is the first sale or new issue market. When a firm (or government) sells its securities to the public, it is a primary transaction. The first public sale of stock by a firm is the initial public offering (IPO); a subsequent sale by the firm is called a seasoned equity offering (SEO). After a bond or share is in the hands of the public, any trading in the security is said to be in the secondary market. Purchases of securities in the primary markets are usually made through investment bankers who originate, underwrite, and sell new issues to the public. In the usual case, a firm will arrange to "float" an issue through its bankers. The firm will be given a price for its securities that reflects market conditions, yields on equivalent securities (either the company's or those of similar concerns), and the costs involved to the investment bankers to distribute the stocks or bonds. Title to the securities is customarily taken by the underwriting syndicate (several banking houses), although small corporations usually have to settle for a best efforts distribution in which the bankers merely act as selling agents for the company.

The primary market (new issue market) has been quite popular for speculative investors. The reason for this popularity is the fantastic price movements experienced by many stocks after initial sale (IPOs). In the late 1990s, it was not unusual for newly public stocks to double or even quadruple in the first day of trading. Some "high tech" stocks went up by a factor of ten or more within days or weeks of their IPO. It was no wonder that just the mention of a new issue was often enough to get investors clamoring for "a piece of the action." It is interesting to note that this is not a new phenomena, and nearly all bull (rising price) markets for decades (actually centuries) have featured startling performers that rose to unbelievable levels even though these were brand new (or, in any case, not very seasoned) companies. For a while in 1999 and early 2000, just about any company with "dot com" or "e" or "i" in its name seemed to be able to go public and have the stock price skyrocket within hours or, at most, days. Companies that never made money (and some that had never made a sale!) were accorded market capitalizations (number of shares outstanding times price per share) that often exceed those of old-line companies that have been in business for decades.

One "tech" stock that played the game with a vengeance was Aether Systems which provides "wireless data services and software enabling people to use handheld devices for mobile data communications and realtime transactions" (Aether Systems, Inc. Form 10K for 1999, p. 2). Aether went public at $16 per share in October 1999. On March 9, 2000, the stock closed at $315! During the "tech crash" in April, 2000, the stock fell to $65. It rebounded in only a few weeks to well over $100, but subsequently fell to below $5. History suggests that these "highfliers" would eventually collapse in price (with many going bankrupt) when more sober market conditions reappear (as they always must, and, post 2000, did). Many have offered these examples as prima facie evidence of market inefficiency. Peter Bernstein provides numerous other historical examples of people paying ridiculous prices for "growth" in his book Against the Gods: The Remarkable Story of Risk (Bernstein, 1996, pp. 108–109).

In economic theory, traders play an important role in effecting a market equilibrating process. That is, if the price of A is "low" relative to its "real value" and the price of B is "high" relative to its real value, traders will buy A and sell B until "equilibrium" values are established. Of course, there must be some common agreement on just what "real value" means and how such is determined, and the economics literature has searched for this answer for over 200 years. Suppose Sam can buy a pound of chocolate on Fifth Street for $5 and sell it on Sixth Street for $6. He would be advised to buy all the chocolate he could on Fifth, run over to Sixth and sell all he could. Now the very process of Sam's engaging in this activity causes the price on Fifth Street to rise (excess demand) and the price on Sixth Street to fall (excess supply). Indeed, in theory at least, others besides Sam should enter this market, and the price of chocolate should eventually settle (say at $5.50) unless there were transactions costs involved in moving chocolate from Fifth Street to Sixth Street (say, Fifth Street is in New York and Sixth Street is in Houston). Economists have debated at length on how long this process should take (in theory, quite rapidly), and under what conditions others would join Sam in this endeavor. Suppose Sam is the only one who knows chocolate can be bought on Fifth for $5 and sold on Sixth for $6 with virtually no transactions costs. The existence of imperfect knowledge may provide Sam with quite an opportunity. Of course, information then takes on its own value. Issues such as "Why does Sam know about this opportunity?" and "Why don't others?" come into play. Also, suppose it takes equipment to move chocolate from Fifth to Sixth. The requirement of having capital investment may create a barrier to entry (and impute an "opportunity cost" for the alternative use of the equipment) which may prevent others from joining the market. Economists are generally suspicious of "free lunches" and usually search for reasons why the world looks the way it does. Suppose the chocolate on Fifth Street is actually inferior to that for sale on Sixth Street This may well explain the price difference, and it may mean that Sam does not have such a good opportunity after all. Thus, the existence of fairly homogeneous products may be required for this arbitrage opportunity to really exist.

Now let us return from chocolate to stock. In order to evaluate whether opportunities may exist, one should know something about just how trading takes place. Just as Sam had to know how to find Fifth Street and Sixth Street and buy and sell chocolate and judge the quality of chocolate, so must the intelligent investor know about how the stock market functions and who the players are. We have already established some of this above, but it would be wise to identify a few more important elements. First, a securities dealer maintains an inventory of securities in which he or she makes a market by purchasing and selling from his or her own account as a principal. A broker acts as an agent for his or her customers in purchasing or selling securities. On the floor of an exchange this is done through a specialist (a trader charged by the exchange with maintaining a market in the stock). A broker may also act by buying from and selling to dealers. As an agent, the broker is expected to obtain the best available price for the customer and is paid a commission for this service.

The simplest order to a broker to buy or sell a security at the best available price is called a market order. In the dealer market (sometimes called the over-the-counter, or OTC, market), the broker would check dealer quotes and execute the order at the best available price. On the floor of the NYSE, the floor broker for the customer's firm would walk (or transmit electronically) to the post where the security is traded. From the assembled group of other floor brokers, floor traders (who trade for their own account), and the specialist, the customer's broker would determine the best available price and execute the order. There are, however, other types of orders. A limit order includes a maximum (minimum) price that the customer is willing to pay (receive) to buy (sell) the stock. A stop order contains a price above (below) the current market price of the stock that, if reached by the market, the customer desires to trigger a buy (sell) market order. Since it is quite likely that neither stop nor limit orders could be executed immediately, the floor broker would instruct the specialist to enter them in his "book" for execution when their terms were met. A stop limit order performs like a stop order with one major exception. Once the order is activated (by the stock trading at or "through" the stop price), it does not become a market order. Instead, it becomes a limit order with a limit price equal to the former stop price. For example, Smith places a stop limit order to sell stock with a stop price of $50 a share. As with the stop order, once the stock trades at $50, the order is triggered. However, the broker cannot sell it below $50 a share no matter what happens. The advantage of this order is that the buyer sets a minimum price at which the order can be filled. The disadvantage is that the buyer's order may not be filled in certain fast market conditions. In this case, if the stock keeps moving down, Smith will keep losing money.

After a stock split or a dividend payout, the price on all buy limit orders and the stop price on sell stop and sell stop limit orders is adjusted. For example, if Jones places an order to buy 100 shares of XYZ Corporation at $100 a share and the stock splits 2 for 1, the order will automatically be adjusted to show that he wants to buy 200 shares of XYZ at $50, reflecting the split. Other restricted orders include the following:

The major functions of the specialist (mentioned above) are to execute the orders in his book and to buy and sell for his or her own account in order to maintain an orderly market. To limit possible abuses, the specialist is required to give the orders in the book priority over trades for his or her own account and to engage in the latter in a stabilizing manner. The larger blocks of stock being traded on the exchanges in recent years have caused the capital requirements for specialists to be increased, and rule violations (such as destabilizing trading) are investigated. Even the EMH advocates, however, agree that the specialist's book constitutes "inside information "and this group can earn above-normal profits.

In the past, NYSE designated commissions were charged by member firms on a 100 share (round lot) basis. No discounts were given. Since May 1, 1975 (known as "May Day" to many retail brokers), discounting has been allowed in a deregulated environment. For large transactions, as much as 75% of a commission might be discounted by the larger retail brokers (such as Merrill Lynch). Even larger discounts are now provided by firms that call themselves discount brokers (such as Charles Schwab), and some deep discount brokers are charging as little as $5 per transaction for market order trades done over the Internet. Some are even free if a large enough balance is kept in the brokerage account; and for larger individual accounts (e.g., $100,000), many brokers are now allowing unlimited free trading for an annual fee of 1% to 1.5% of the portfolio value.

Reduced revenues resulting from negotiated commissions coupled with the higher costs of doing business altered the structure of the brokerage industry. A number of less efficient houses collapsed, were merged with stronger concerns, or undertook voluntary liquidation. During the 1970s, several large houses failed and millions of dollars in customer accounts were jeopardized. In order to prevent loss of investor confidence, the Securities Investor Protection Corporation (SIPC) was established to protect the customers of SIPC member firms. The SIPC provides $500,000 ($100,000 cash) protection per account in the event of failure. This arrangement does not protect against trading losses but rather in the event of failure of brokers to satisfy their agency responsibilities. Suppose Mr. X is a customer of ABC & Co. which is a member of the SIPC. Suppose further that X keeps his stocks in custody with ABC (that is, "street name") and the firm goes bankrupt. X would be able to look to the SIPC to make good on the value of his investments up to $500,000. Many brokerage firms purchase insurance to provide protection above $500,000 and the capital requirement for firms has been increased. Thus, a more concentrated, hopefully stronger, and more efficient brokerage community has emerged over the past three decades. This has made it possible for the transactions costs to be reduced tremendously; and this, in turn, should have made markets relatively more efficient than they were, say, 30 years ago.

A caveat should be noted here: Substantially lower commissions and Internet trading have inevitably led to the phenomenon of the undercapitalized "day trader." These are individuals who may have as little as $5,000 who speculate on small price movements in a particular stock within a single day's trading. This phenomenon was not possible when commissions were large, but with $5 trades almost anyone with a computer and Internet access can play the game. The evidence suggests that most of these traders get wiped out, or suffer large percentage losses to their portfolios, within months of initiation of trading. Thus, even in the biggest bull market in history (ending in the year 2000), there were traders who lost most of their money by treating the stock market like a computerized Las Vegas. Interestingly, there are economists who contend that this added "liquidity" has actually made the markets more efficient! (See Malkiel [1999] for an advocate of such reasoning.)

A final note on the mechanics of securities trading: From the beginning of the NYSE in the late eighteenth century, stocks (originally U.S. government securities) were traded in eighths, quarters and halves. Some stock even traded in fraction of eighths, but the basic trading unit was the 1/8, which was one-eighth of a dollar or $0.125. This peculiarity was a result of having the old Spanish dollar (which was divided into eighths and thus called "pieces of eight") being a major currency during the U.S. colonial era. After the decimal U.S. currency system was effected, securities continued to trade in eighths, first as a matter of convenience and later because it increased bid/ask spreads where dealers make most of their money (buying at $11 7/8 and selling at $12 is much more profitable than buying at $11.99 and selling at $12). In late 1999 and early 2000, there was a movement initiated by the SEC and adopted by the stock exchanges (and the Nasdaq) to change trading to decimal units. Thus, we no longer buy (and sell) stocks at prices such as $163/8 or $301/8; rather, we may buy or sell at the more sensible $16.37 (or $16.38) or $30.12 (or $30.13). This may not seem like a big change, but has made the arithmetic of trading much simpler. (Quick Mental Check: XYZ goes from $105/64 to $1013/32. What is your profit? How much easier is it to calculate an advance from $10.08 to $10.41!) Also, the greater competition has reduced spreads such that dealer margins have been reduced in favor of investors.

Many people feel that a major element contributing to the efficiency of the U.S. securities markets is the regulation of those markets by the federal government. Before 1933, there were no laws governing stock-exchange or investment-house activities, and widespread manipulation and questionable practices abounded. Corporations were not required to provide information to investors, and fraudulent statements (or no statements at all) were issued by any number of companies. As securities speculator Joseph P. Kennedy (father of future President John F. Kennedy) once remarked to one of his partners, "It's easy to make money in this market.... We'd better get in before they pass a law against it" (Kennedy, 1999, p. 367). The excesses of the 1920s were attributed in part to the lack of comprehensive legislation regulating the securities industry, and with the coming of the New Deal a number of laws were indeed passed to prevent a recurrence of the events that led to the 1929 crash.

The Securities Act of 1933 (the '33 Act) requires full and complete disclosure of all important information about a firm that plans to sell securities in interstate commerce. Issues of securities exceeding certain dollar limits, and all issues sold in more than one state, must be registered. A prospectus must be prepared by the issuing company and distributed to anyone who is solicited to buy the securities in question. The prospectus must include all pertinent facts about the company, such as recent financial reports, current position, a statement about what will be done with the funds raised, and a history of the company. Details about the officers and directors of the company are also required.

The Securities Exchange Act of 1934 (the '34 Act) established the Securities and Exchange Commission (the "SEC" or the "Commission"). It also regulates the securities markets and institutional participants in the market, such as brokers and dealers. All exchanges are required to register with the Commission, although much of the supervision of individual exchanges is left up to the governing bodies of each exchange. Amendments to the act (e.g., the Maloney Act of 1938) now also include the OTC markets, although broker-dealer associations are accorded the same self-regulatory authority as the exchanges enjoy (see discussion of self-regulation below.) The '34 Act also calls for the continual reporting of financial information by firms that have "gone public" and a major part of the financial (and other) information flow from reporting companies to the public is done pursuant to this act and amendments to it. Interestingly, President Franklin Roosevelt appointed Joseph P. Kennedy (the speculator mentioned above) to be the first Chairman of the SEC. ("a choice often compared to putting the fox in the henhouse or setting a thief to catch a thief " (Kennedy, 1999, p 367)!

The Investment Company Act of 1940 regulates the management and disclosure policies of companies that invest in the securities of other firms. Under the act, investment companies may be organized as unit trusts, face-amount certificate companies, or management investment companies. Only the last classification is currently significant, and it is further subdivided into open-end and closed-end management investment companies. Closed-end companies sell a fixed number of shares, and these shares then trade (often at a discount to net asset value) just like other shares. Many closed-end funds are listed on the NYSE. Some even issue preferred stock (or income shares) and borrow money. Open-end companies are better known as mutual funds and are required to redeem their shares at net asset value upon demand; because of this requirement, they may not issue long-term debt or preferred stock. If a fund registers with the SEC, agrees to abide by the above rules, invests no more than 5% of its assets in the securities of any one issuer, holds no more than 10% of the securities of any issuer, pays at least 90% of its income out to fund shareholders, and meets other rules, it may pay taxes only on earnings retained. Capital gains and dividends (interest) earned are paid out to the holders of the fund's shares who pay taxes at their respective individual or institutional rates.

Other acts that are important include the Public Utility Holding Company Act of 1935, which regulates the operations and financial structure of gas and electric holding companies; the Trust Indenture Act of 1939, which requires that bonds (and similar forms of indebtedness) be issued under an indenture that specifies the obligations of the issuer to the lender and that names an independent trustee to look after the interests of lenders; and the Investment Advisors Act of 1940, which requires the registration of investment counselors and others who propose to advise the public on securities investment.

One of the major excesses of the pre-1933 era was the practice of buying stocks on low margin. Margin purchases are those for which the investor does not advance the full value of the securities that he or she buys. Thus, if an investor bought one hundred shares of General Motors at 60 on 50% margin, he would only put up $3,000. The remaining $3,000 would be borrowed either from his broker or a bank. Margin purchases may increase the rate of return earned by an investor. If General Motors went up 10% to 66, the investor in the above example would have made $600/$3,000 = 20%. They also increase the degree of risk exposure. If GM went down 10%, the loss would be 20%. During the late 1920s, investors were buying stocks on less than 10% margin. Large rates of return were earned by everyone so long as stock prices were advancing. When prices began to skid in late 1929, however, many people were wiped out in a matter of days. Investors tended to build their margin positions as prices rose by buying more shares with the profits earned. Thus, a man might have put $1,000 into stock worth $10,000 in January 1929. As prices advanced by 10%, say, in February, he might have used his profit to buy another $9,000 worth of stock. His commitment was still $1,000, but he controlled $20,000 in stock. As prices rose further, he might have increased his position to $25,000. But suppose prices fell just a little, say 4%. This decline would be enough to wipe out his investment completely! Such a decline began during October 1929, and many investors were sold out of their stocks as prices fell. The process of liquidating shares as prices went below margin levels caused further price deterioration that, in turn, forced more liquidations. The snowballing effects of this phenomenon produced the major crash of October 29, 1929, and contributed to the subsequent collapse of both the stock market and the American economy.

Because of the problems directly traceable to margin purchases, the Securities Exchange Act of 1934 gave the board of governors of the Federal Reserve System the power to set margin requirements for all stocks and bonds. Since 1934, margins have been allowed as low as 40% but have also been as high as 100% (no borrowing permitted). To some extent, the sobering experiences of 1929 caused a natural reaction against margin purchases in subsequent years. Nevertheless, most participants in the market today have only read about 1929 and would, if given the chance, follow their forefathers down the same speculative path. To protect them and society from such excesses, extremely low margins are no longer permitted.

Another practice that caused problems prior to 1933 was the short sale. When one sells a security he or she does not own but borrows from someone else to make delivery, he or she is said to sell that security short. The device has been used for years and can be defended on economic grounds even though it does sound a bit immoral to be selling something one does not own. In practice, the short sale is consummated by specialists (who have responsibility for maintaining an orderly market on the NYSE) and dealers far more frequently than by the investing public. The average investor might consider selling short a security if she believed its price was going to decline. She would simply call her broker and ask to sell so many shares of such and such company short at a given price. If the broker could find the shares for the customer to borrow (usually from securities held by the broker in his own account or securities margined with the broker), the transaction could be effected. Because short selling can tend to exacerbate downward movements in stock prices, it is easy to see how speculative excesses could occur through unregulated use of the device. Thus, the Securities Exchange Act of 1934 allows the SEC to set rules for short selling. There are several regulations in effect now governing the practice, the most important being the "uptick" requirement. This rule prevents a short sale while a stock is falling in price. Thus, if a stock sells at $40, then $39.50, then $39, no short sale could be effected until there is an advance above $39.

Since the average securities firm functions as investment banker (representing the issuing firm), broker (representing the customer), and dealer (representing itself) simultaneously, the potential for conflict of interest is great. Many of the laws previously discussed were passed to protect the general public when such conflicts arise. These laws, in turn, provide for substantial self-regulation. This is manifested by exchange regulations for member firms and NASD (National Association of Securities Dealers) rules for most others, who subject themselves to such rules in order to obtain securities from other NASD firms at less than the price to the general public. NYSE members must restrict all transactions in listed stocks to the floor of the exchange, even though the larger firms could merely match buy and sell orders in their own offices. NASD firms may only trade with their customers if their price is the best obtainable and must reveal if they acted as principal on the other side of the transaction. Any research recommendations by broker-dealers must indicate if the firm holds a position in the stock. Other regulations call for ethical behavior on the part of members by prohibiting such practices as: (1) the spreading of rumors; (2) the recommending of securities clearly inappropriate for a given customer; and (3) the encouraging of excessive numbers of transactions (called "churning") in a given account. Although many of these rules have protected the public, others are clearly designed to protect the economic position of the broker-dealer community itself.

The Securities Exchange Act of 1934 defines officers, directors, and holders of more than 5% of the shares of a firm as insiders. Such persons are required to file a statement of their holdings of the firm's stock and any changes in such holdings (within a month) with the SEC. Profits made by insiders on shares held less than six months must also be reported and may be legally recovered by the firm (through a shareholders' derivative suit if necessary); in addition, malfeasance suits could be filed for other injuries to shareholder interests. Over the years, holdings of related persons have come to be included in the determination of whether the 5% rule were met and persons related to insiders were also considered to be insiders for the purpose of the law. In general, the principle was established that insiders and their relatives should not gain a special benefit over other shareholders by virtue of the information about the firm they possess. The Texas Gulf Sulphur case of the mid-1960s, in which corporate insiders withheld information about a minerals discovery until they could obtain stock, clearly reestablished this point through both civil and criminal action.

Several other cases expanded the concept of insider information. In the cases of Douglas Aircraft and Penn Central in the 1970s, brokerage houses obtained insider information (of bad earnings and impending bankruptcy, respectively) and informed selected institutional investors before the general public. Subsequent suits and exchange disciplinary actions against the brokerage houses involved, and suits against the institutions, indicate that second- and third-hand possessors of inside information may also be classed as insiders. A securities analyst was charged in the Equity Funding case some years ago for providing information to selected investors that did not even originate from the company itself but rather from former employees. We clearly have moved in the direction of classifying insiders more on the basis of the information they possess than the position they hold in regard to the firm. Although such a situation would tend to validate the EMH by default, its long-run implications for investigative research analysis and individualistic-portfolio management are not encouraging.

When the EMH postulates that only "normal" returns can be earned in the stock market, an implicit assumption is made that there is some sort of average that summarizes stock market performance in general. In fact, it is extremely difficult to calculate measures of this sort. Perhaps the most widely used average is the Dow Jones Industrial Average (DJIA) that appears in the Wall Street Journal each day. The DJIA is computed by taking the price of each of 30 selected blue-chip stocks, adding them, and dividing by a divisor. The divisor initially was the number of stocks in the average (originally 12), but because of the obvious biases of stock splits (a two-for-one split would tend to cause the price of a share to fall by one-half), the divisor was adjusted downward for each split. The divisor now is well below one, which, in reality, makes it a multiplier. In addition to the DJIA, there is a Dow Jones Transportation (formerly rail) Average of 20 stocks, a Dow Jones Utility Average of 15 stocks, and a composite average of all 65 stocks.

Dow Jones also calculates market indices for a number of foreign markets, an Asia/Pacific Index and two World Indices (one with U.S. stocks and another without). Each is computed in the same manner as the DJIA. For many investors, the Dow Jones averages are the market. When an investor calls his broker to ask what the market is doing, he is very likely to get a response such as "down 56.75." The broker means, of course, that the DJIA is down 56.75 points. This information may have very little to do with what the investor really wants to know (that is, how are my stocks doing?). The DJIA is not an overall indicator of market performance, although many use it as if it were. In fact, only blue-chip stocks are included in the average. The thousands of other stocks that are not blue chips are not represented. Moreover, the DJIA has been criticized by many even as a measure of blue-chip performance. Because the DJIA merely adds the prices of all included stocks before applying the divisor, a stock that sells for a higher price receives a larger weight in the measurement.

The difficulties associated with the Dow Jones averages have led to the development of other stock price averages and indexes. Standard & Poor's computes an industrial index, a transportation index, a utility index, and a composite index (500 stocks) that include both the price per share of each security and the number of shares outstanding. These figures thus reflect the total market value of all the stocks in each index. The aggregate number is expressed as a percentage of the average value existing during 1941 to 1943, and the percentage is divided by 10. The S&P indexes are better overall measures of stock market performance than the Dow Jones averages because more securities are included. Furthermore, the statistical computation of the S&P indexes is superior to the Dow Jones method.

There are a number of other indexes that are also prepared. Both the New York and American Stock Exchanges compute measures that include all their respective stocks. The NYSE Common Stock Index multiplies the market value of each NYSE common stock by the number of shares listed in that issue. The summation of this computation is indexed, given the summation value as of December 31, 1965. The American Stock Exchange average simply adds all positive and negative changes of all shares and divides by the number of shares listed. The result is added to or subtracted from the previous close. The NASD, with its automated quotation service, computes a composite index based on the market value of over 5,000 OTC stocks plus indices for six categories representing industrials, banks, insurance, other finance, transportation, and utilities. The broadest index is calculated by Wilshire Associates. Their Wilshire 5000 Equity Index is based on all stocks listed on the New York and American Stock Exchanges plus the most actively traded OTC stocks. Although there is no single perfect indicator of average performance, many analysts are tending to favor the Wilshire Index as the most broadly indicative. Nevertheless, most observers do not ignore the Dow Jones averages because so many investors are influenced by them. Fortunately (at least for measurement purposes), there is a high positive correlation between the price movements of all stocks. Thus, if most stocks are going up (or down), almost any stock price measure will indicate this.

It is important to understand the institutional aspects of the securities markets in order to be a successful participant in them. The various investments media and the environment in which they trade are important elements in this regard. Of all the forms of securities, common stock and derivatives of common stocks are the most romantic but are also the most difficult to analyze.

There is a school of thought that maintains that the current price of a stock contains all available information about that stock and only new information can change equity returns. This theory of stock market behavior is called the efficient market hypothesis (EMH). The EMH has been tested over the years by a number of scholars. It was generally endorsed by financial economists in the 1970s, but most practitioners never accepted the theory. Today, even many financial economists no longer accept the EMH, at least without qualification.

A crucial assumption of the efficient market hypothesis is that stock prices reflect all public information. A major form of such information is that supplied by research agencies and services. Reports periodically prepared by brokers and investment advisory companies are designed to aid the investing public in making decisions. An important feature of the established service and agency reports is that they are available to large audiences. Thus, the data that are contained in them could be expected to be incorporated in stock prices just as soon as the information is published. Other information that is not so easily transmitted or interpreted appears in the financial press. Much of this information requires special expertise or training for proper understanding.

The efficient market hypothesis postulates the existence of large, well-behaved securities markets. For a market to generate a unique (no less efficient) price, it must be sufficiently large so that any buyer (or seller) can purchase (sell) whatever quantity he or she wishes without affecting the market price. The securities markets satisfy this requirement for some securities but not for others. In general, stocks traded on an organized exchange will have a broader market than those that are traded over the counter, because exchanges have listing requirements designed to guarantee market depth. Securities trading in the over-the-counter market may be either primary or secondary in nature. The primary market exists for the distribution of new securities. The secondary markets include both listed and OTC securities that are in the hands of the public. New-issue securities (primary market) are sold by investment bankers to investors. The initial public offering (IPO) market has been very popular at times among speculators.

A major element often cited as contributing to the efficiency of the American securities markets is the regulation provided by the U.S. government. After the 1929 stock market crash, a number of laws were passed that were designed to correct some of the abuses that existed in the past. Disclosure requirements were established, and the Securities and Exchange Commission was created to supervise the investments business. One of the excesses of the pre-1933 era was the practice of buying stocks on margin. Use of this device is now regulated by the board of governors of the Federal Reserve System. Another practice that caused problems prior to 1933 was the short sale. This process is still permitted, although the SEC may make rules governing its use.

In order to determine whether one has earned above (or below) market returns, one must have a good measure of the average performance of stocks in general. No perfect indicator exists. The most widely used average is the Dow Jones Industrial Average. The DJIA is primarily a blue-chip measure, although many investors use it for overall market activity. Standard & Poor's computes indices that have a larger base than the DJIA. The S&P measures are also statistically superior to the Dow calculation. There are a number of other indexes and averages that are also computed. Fortunately (at least for measurement purposes), there is a high positive correlation among the price movements of all stocks. Thus, if most stocks are going up (or down), almost any stock price measure will indicate this.

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